The Components of Binary Option Pricing

In this lesson
• What factors go into the price of a binary option?
• How does the binary option price reflect the probability of the option expiring in the money?
• Why does an option with little time remaining have a price closer to either zero or 100 than an option with lots of time till expiration?
• What is volatility and how does it affect the price of binary option?

By this point you should understand what a binary option is and the benefits of its capped risk-reward. Now let's look at what goes into a binary option's price and how it changes with the movement of the underlying market.

The pricing of binary options is straightforward. If you have traded options before, you may know about advanced topics like the Black-Scholes pricing model or the delta and gamma. If you know that stuff, great. But you don't need to learn it to trade binary options.

What Buyers and Sellers Think is Probable

Binary options are priced between zero and 100. That price reflects what the buyers and sellers in the market collectively believe is the probability of the binary option expiring above the strike price (in the money).

To get a rough but useful idea of the probability, just find the mid-point between the contract's bid and offer price, the prices that sellers and buyers are paying, respectively.

For example, if the binary contract EUR/USD > 1.1200 is trading at a bid of 30 and an offer of 34, you take the mid-point between the two, which is 32. That means the market is saying there is about a 32% probability of the EUR/USD rate being above 1.1200 at expiration. The seller, therefore, has a 68% probability at that moment of being correct.

How does the market form this view? A few components go into shaping the price. They are the underlying market and its relationship to the strike price, the time remaining, and the market volatility.

Price and the Underlying Market

If the underlying market is higher than the strike price, the binary option price will typically be above \$50. A binary option is based on the condition that the market will be above the strike price at expiration. So if the underlying market price already is above the strike price before expiration, the probability is that the binary will finish above it. The higher price reflects that expectation. The odds are in the buyer's favor at that time.

Conversely, if the underlying market price is lower than the strike, the probability is lower that the binary will expire in the money. That makes the price go lower as well. The odds at that moment are in the seller's favor, not the buyer's.

In other words, if you are a buyer:

• The further below the strike price the underlying market is, the lower the price of the binary, down to the lower limit of zero.
• The further above the strike price the underlying market goes, the higher the price of the binary option, until the binary approaches its maximum of \$100.

If you're a seller, the reverse is true.

For example, if a market has an average daily range of 17 points, and the underlying market is currently over the strike price by 15 points, the binary price will be higher than a contract that is only 1 point over the strike. At expiration, however, it doesn't matter since the binary option's price can only be zero or \$100.

Factoring in Time

All binary contracts have an expiration time at which they will be worth either zero or 100. The more time is left in the contract, the greater the chance that either outcome could happen. If you want to drive 1000 miles and you have 3 days to do it, the probability is pretty high that you'll succeed. If you have 5 hours, the probability is low.

Let’s go back to the example of a market with an average daily range of 17 points. If this market is 8 points above the strike price, but there is a full day before expiration, the probability will be over 50, but still near the middle of the 0-100 price range. That's because it still has a full day in which it could lose those 8 points. If the same contract had only 15 minutes left until expiration, the binary price would be closer to 100 since it has only 15 minutes left in which it could lose those 8 points and become unprofitable.

If a binary option has little time left until expiration and the underlying market is trading right around the strike price, the binary option's price can make some extreme moves. That's because only one tick of movement means the difference between a zero outcome and a \$100 outcome. With only minutes or seconds left, an option worth \$80 could drop to \$20 on only a few ticks of movement in the underlying market. Or a \$20 option could go to \$80. This is one way binary options can give you more profitable results than trading the underlying market.

Watch the Nadex 5-minute binary options in forex to see this happen again and again. We designed those 5-minute options for traders who like fast results, with the protection of defined risk.

Volatility: Anything Can Happen

You could take several college courses in market volatility and learn about standard deviation and implied vs. historical vs. relative volatility, but to trade on Nadex, you just need to know what volatility looks like in the movement of the price.

Volatile markets make bigger moves. If a market has an average daily range of 17 points, during a period of high volatility its range may expand to 25 to 30 points or more.

When markets are less volatile, these ranges tend to contract. A market that typically moves 17 points in a day might only move 6 or 8 points.

The more volatility there is in the underlying market, the closer the price will be to the middle of the zero to 100 range.

One day, you may see a binary priced with a bid/offer of 76/80 with 8 hours remaining and then the next day see the same binary with the same time remaining priced at only 62 bid / 66 offer. Because the market is more volatile on the second day, sellers are more averse to risk, bringing the prices closer to the middle of the range.

Volatility is a factor in the binary option's price. You can also use it as a factor in your trading strategy. If a market which typically moves 17 points in a day has only moved 8 points in low volatility market, then a binary option with a strike price 15 points below the market price has a higher probability of staying in the money until expiration. In such a slow-moving market, it is less likely to move 15 points that day, unless the situation changes. Of course, it always can, but the probability is greater than usual that it will stay above the strike price. You can look at the chart to see the volatility and use that information to decide whether to take the trade. Low volatility is not hard to spot—it's when the price is meandering sideways and not moving up or down very much.

At this point you should understand:
• The three factors that shape the price of a binary option
• The way that the binary option price reflects the probability of a profitable outcome
• How time, volatility, and the price of the underlying market work together to affect the price of the binary option

Congratulations!

You've completed this course.

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